Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
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EQ: The topic of rising interest rates and the Fed taking away the punch bowl has been going on for quite a while now. Do you get the sense that the market has a better idea of an end date for near-zero interest rates?
Stovall: I think the market does have more of a confirmation of what they had anticipated early on. The expectation was that the tapering program would conclude sometime in the fourth quarter, and the Fed would then start to raise interest rates by possibly the middle of 2015. In effect, that’s what Fed Chair Janet Yellen said at her inaugural press conference.
Because her comments were a little more definite with the six month timeline—which would imply that it could begin before mid-year 2015--investors became a little unnerved by the possibility that rates could start to rise earlier than anticipated.
EQ: You noted in this week’s Sector Watch that a hike in interest rates is most likely not happening anytime in the near future. How much should this impact normal investors when making their investment decisions right now?
Stovall: In my opinion, interest rates are always the most important driver of share prices because they affect intrinsic value for stocks based on a discounted cash-flow model. They also affect the interest expense for those companies that borrow money. Also, the higher rates go, the more bonds present an attractive substitute for stocks.
So investors should always keep an eye on interest rates, but I don’t think they have to worry about rates rising dramatically anytime soon. Our expectation is that the Fed probably won’t start raising rates until they do see that the economy is posting a significant improvement in growth, which we don’t really see that happening until probably the middle of 2015. We see full-year GDP advancing by 2.8 percent, down from the original estimate of 3 percent because of the relatively weak start to the year and the effects of worst-than-expected winter weather.
Also, we think corporate earnings for all of 2014 will come in at close to 7.5 percent, versus the earlier estimates of 10 percent. So again, I don’t really think that the economy or corporate earnings are growing at a pace that needs to be reined in.
EQ: When rates rise, most investors recognize that as an end to a high growth environment for assets. But that doesn’t necessarily mean there’s no growth. What did you find when looking at various asset classes when rates were on the rise?
Stovall: Investors pretty much assume that once rates start to rise, share prices would start to fall but that is actually not the case. If you go back to 1976, and look at how the major asset classes have performed on average whenever the yield on the 10-year note has been rising within a particular month, only bonds--as represented by Barclays Aggregate Bond Index--have posted a decline.
Commodities, as tracked by the S&P GSCI, averaged the best performance with a monthly gain of 1.1 percent in a rising interest rate environment. Stocks as tracked by the S&P 500 rose an average of 0.9 percent, and real estate investments trusts as tracked by the NAREIT Equity REITs index advanced by an average of 0.5 percent. All of these numbers include dividends reinvested.
Obviously, the higher we go with interest rates, the greater the effect they might have on these asset classes. But during all periods in which we saw a rise in the yield on the 10-year note, these commodities and equity investments held up relatively well as compared with bonds.
EQ: Was there a clear winner in terms of where investors should be looking? Is there a possibility that investors will be moving into commodities like gold or other types that have been out of favor recently?
Stovall: Traditionally, gold has not been an outperformer in a rising-interest rate environment because gold pays no dividend. While it is traditionally an inflation hedge, it does tend to have a negative correlation with inflation rates. So when rates rise, the price of gold falls.
However, industrial commodities tend to do relatively well because the reason that rates are rising is because we are seeing an improvement in economic growth and investors are requiring higher interest rates to offset the prospects of increased inflation.
So commodities do tend to do well, but gold itself does not tend to do well.
EQ: If bonds are going to take a hit, are dividend stocks and bond-proxy investments to be avoided as well?
Stovall: I wouldn’t make a blanket statement that they are to be avoided, but I would remember that since 1970, looking at total returns for the 10 sectors of the S&P 500, the best performances came from the cyclical sectors.
Information Technology, Energy, Materials, Consumer Discretionary, and Industrials in descending order posted the stronger average total returns.
Telecom Services, Financials, and Utilities actually posted average total return declines during the months in which we saw an increase in the 10-year note. Telecom Services and Utilities are traditionally the highest-yielding of the 10 sectors. Financials also tend to get squeezed because the yield curve tends to flatten as short-term rates rise. That tends to hit the financial stocks more than others.
In general, the cyclicals tend to do better than defensives, but it doesn’t necessarily mean you have to rotate into one and out of the other every time.